In Rev. Rul. 2011-24, the IRS provided
guidance for determining whether a taxpayer that provides
telecommunications services derives gross receipts from
services, leasing or renting property, or a combination of the
two, for purposes of the domestic production activities
deduction under Sec. 199.

Facts

The revenue ruling presents three hypothetical
situations.

Situation 1:Z corporation provides
telecommunications services, including the transmission of
voice, data, and video communications. Z contracts with A corporation, which has
multiple business locations and is not in the
telecommunications industry, to transmit A’s telecommunications.
Under the contract, Z
must transmit A’s
telecommunications at A’s desired times to A’s desired destinations
and at a certain speed. A must pay Z for transmitting the
telecommunications. If Z cannot transmit A’s telecommunications
according to the terms of the contract, then Z must give A a service credit.

Z’s optical and
digital transmission equipment, usually a synchronous optical
network (SONET) ring, and the associated public switched
telephone network (PSTN) are used to transmit A’s telecommunications. The
SONET ring interconnects multiple business locations
designated by A to
transmit telecommunications among A’s business locations
without transmitting them to Z’s PSTN. Additionally, the
SONET ring connects to Z’s central office,
switching center, or remote terminal to transmit
telecommunications to and from Z’s PSTN.

The PSTN
consists primarily of fiber optic cable and copper cable that
connects switching centers with each other and to remote
terminals. The PSTN is owned by Z and is not dedicated to
A or to any of
Z’s other
customers. The PSTN provides different pathways to transmit
telecommunications to and from A’s business locations. The
SONET ring and PSTN assets used to transmit A’s telecommunications
include: (1) network electronics, such as multiplexers,
switches, routers, digital cross-connects, and optical and
digital transmission equipment; (2) fiber optic cable and/or
copper cable; (3) network facilities such as a central office;
and (4) software.

A owns telecommunications equipment that connects with
the SONET ring to allow transmission of the
telecommunications among A’s business locations or to the PSTN and transmission of
others’ telecommunications to A from the PSTN. A’s equipment includes a router, channel service or data
service unit, and a diagnostics modem (customer-premises
equipment). Z is not required to provide services related to A’s customer-premises equipment.

Z owns, installs,
operates, and maintains the SONET ring and PSTN. Z will replace any SONET
ring and PSTN assets when required. Under the contract, A must grant Z reasonable access to
A’s premises to
install, inspect, test, rearrange, maintain, repair, or remove
any SONET ring assets located on A’s property. Z repairs and maintains the
SONET ring and PSTN at no additional charge to A. A cannot install, inspect,
test, rearrange, maintain, repair, or remove any component of
the SONET ring or PSTN.

Situation 2: The facts are the same as in
Situation 1, except that A does not have multiple
business locations, and Z uses a dedicated circuit,
instead of a SONET ring, to transmit A’s telecommunications to
the PSTN and others’ telecommunications from the PSTN. Z transmits all
telecommunications to or from A through the PSTN. Z’s dedicated circuit
comprises Z’s
equipment, including fiber optic or copper cable and
point-of-presence equipment, and dedicated or shared
equipment. Z
generally does not notify A if Z repairs the dedicated
circuit or PSTN. Z
may notify A if Z upgrades the dedicated
circuit or PSTN. A
cannot stop Z from
making any necessary repairs or upgrades to the dedicated
circuit or PSTN.

Situation 3: The facts are the same as in
Situation 2, except that A does not own the
customer-premises equipment required to connect with the
dedicated circuit to allow transmission of A’s telecommunications. As
part of the contract, Z must provide the
customer-premises equipment and support services in relation
to that equipment. The contract states that Z is leasing the
customer-premises equipment to A, but does not state the
lease amount. Z
delivers and installs the customer-premises equipment on A’s premises. If necessary,
Z provides
telephone support services to A’s designated employees
related to diagnosing problems and repairing and replacing the
customer-premises equipment. Z also may remotely perform
maintenance or diagnostic tasks.

A’s designated
employees complete any required repair or replacement, and
A is liable for any
repair charges or the replacement cost of the equipment if it
is damaged or lost. A
can relocate or modify the customer-premises equipment and may
attach it to non-Z
equipment with Z’s
authorization, which Z may not unreasonably
withhold. At the end of the contract term, A must return the
customer-premises equipment or make it available to Z for removal. If A fails to return the
equipment, A will be
liable to Z for the
customer-premises equipment’s then-current market value. A is liable for any costs
of restoring the customer-premises equipment, beyond those of
ordinary wear and tear.

Law and
Analysis

Sec. 199(a)(1) allows a deduction equal to 9%
(3% for tax years beginning in 2005 or 2006, and 6% for tax
years beginning in 2007, 2008, or 2009) of the lesser of (1)
the taxpayer’s qualified production activities income (QPAI)
for the tax year, or (2) taxable income (determined without
regard to Sec. 199) for the tax year, subject to the
limitation that the deduction may not exceed 50% of the
taxpayer’s W-2 wages for the tax year that are allocable to
domestic production gross receipts (DPGR). Sec. 199(c)(1)
defines QPAI as an amount equal to the excess (if any) of (1)
the taxpayer’s DPGR for the tax year over (2) the sum of the
cost of goods sold that are allocable to DPGR and other
expenses, losses, or deductions that are properly allocable to
DPGR.

Sec. 199(c)(4)(A)(i)(I) defines DPGR as the
taxpayer’s gross receipts that are derived from any lease,
rental, license, sale, exchange, or other disposition of
qualifying production property that was manufactured,
produced, grown, or extracted by the taxpayer in whole or in
significant part within the United States. Under Regs. Sec.
1.199-3(i)(1), applicable federal income tax principles apply
in determining whether a transaction is in substance a lease,
rental, license, sale, exchange, or other disposition, a
service, or a combination of any of these. Regs. Sec.
1.199-3(i)(4)(i)(A) prohibits gross receipts derived from the
performance of services generally from qualifying as DPGR.

Under Regs. Sec. 1.199-3(i)(6)(ii), gross receipts
derived from customer and technical support, telephone and
other telecommunications services, online services (e.g.,
internet access services or online banking services), and
other similar services are not gross receipts derived from a
lease, rental, license, sale, exchange, or other disposition
of computer software.

In determining whether
the contract in each of the three hypothetical situations
outlined above is a lease or rental, or a service contract,
the IRS considered Rev. Rul. 68-109; Rev. Rul. 72-407; Xerox Corp., 656 F.2d 659
(Ct. Cl. 1981); Smith, T.C. Memo. 1989-318;
and Sec. 7701(e)(1). Each of these authorities distinguished
lease or rental arrangements from service contracts, focusing
on factors including the property’s ownership, possession,
use, control, and risk of loss, and whether the property is
part of a broader, integrated system of equipment and
services. Sec. 7701(e)(1) provides that, for purposes of
chapter 1 (which includes Sec. 199), a purported service
contract is treated as a lease of property if the contract is
properly treated as a lease of property, taking into account
all relevant factors, including whether:

The
service recipient is in physical possession of the property;

The service recipient controls the property;

The service recipient has a significant economic
or possessory interest in the property;

The
service provider does not bear any risk of substantially
diminished receipts or substantially increased expenditures
if there is nonperformance under the contract;

The service provider does not use the property
concurrently to provide significant services to entities
unrelated to the service recipient; and

The
total contract price does not substantially exceed the
rental value of the property for the contract period.

The IRS noted that authorities such as those cited
above generally apply federal income tax principles to
determine a single character for a given transaction. However,
Regs. Sec. 1.199-3(i)(1) states that, for Sec. 199 purposes, a
single transaction may have both a service and a lease
element. Therefore, the application of federal income tax
principles described in Regs. Sec. 1.199-3(i)(1) requires an
analysis of relevant factors taken from federal income tax
principles but does not require a determination of a single
character. An analysis of the relevant factors may nonetheless
lead to a determination that the transaction has only a single
character element for purposes of Sec. 199.

Applying
federal income tax principles to Situation 1, the IRS
concluded that Z is
using its SONET ring and PSTN to provide telecommunications
services to A, not
providing a combination of telecommunications services with a
lease or rental of Z’s SONET ring or PSTN to
A. Essentially, in
Situation 1, A
contracts with Z for
reliable telecommunications services, and Z provides those services
using its SONET ring and PSTN, subject to the contract terms
governing the quantity and quality of services that Z must provide A.

The IRS emphasized
that Z maintains
control of the SONET ring and PSTN. In particular, A does not control how
Z uses the SONET
ring and PSTN to provide the services. Further, Z, and not A, has a possessory
interest in the SONET ring and PSTN that Z uses to complete the
transmissions. Z, and
not A, operates,
maintains, repairs, and upgrades the SONET ring and PSTN.
Indeed, A is
prohibited from installing, inspecting, testing, rearranging,
maintaining, repairing, or removing any component of the SONET
ring or PSTN. In the event that Z cannot transmit A’s telecommunications
according to the terms of the contract, then Z is required to provide a
service credit. The SONET ring and PSTN are also part of Z’s broader integrated
operation of transmitting telecommunications. The PSTN is
owned by Z and not
dedicated to A (or
any other of Z’s
customers). Accordingly, the IRS concluded that Z derives its gross
receipts from the performance of telecommunications services
without the lease or rental of Z’s SONET ring and PSTN to
A for purposes of
Sec. 199, and the gross receipts are not DPGR.

In Situation 2, the IRS concluded that Z is using its dedicated circuit and PSTN to provide
telecommunications services to A, not providing a combination of telecommunications
services with a lease or rental of Z’s dedicated circuit or PSTN to A. Essentially, in Situation 2, A contracts with Z for reliable telecommunications services, and Z provides those services using its dedicated circuit and
PSTN, subject to the contract terms governing the quantity
and quality of services that Z must provide. The IRS noted that A does not control the dedicated circuit or PSTN because Z maintains the same control it has over the SONET ring
and PSTN in Situation 1. Additionally, A does not have a possessory interest in the dedicated
circuit and PSTN that Z uses to complete the transmissions. In fact, Z has broader access to a dedicated circuit than a SONET
ring. The dedicated circuit is also part of Z’s broader integrated operation. The dedicated circuit
must connect with Z’s PSTN to transmit telecommunications to and from A’s business location. Therefore, Z derives its gross receipts from the performance of
telecommunications services without the lease or rental of Z’s dedicated circuit and PSTN to A for Sec. 199 purposes, and the gross receipts are not
DPGR.

In Situation 3, the IRS ruled that Z is providing a
combination of telecommunications services using its dedicated
circuit and PSTN and a lease or rental of Z’s customer-premises
equipment to A.
Essentially, in Situation 3, A contracts with Z for reliable
telecommunications services, and Z provides those services
using its dedicated circuit and PSTN, subject to the contract
terms governing the quantity and quality of services that
Z must provide.
However, A also
contracts for the lease or rental of customer-premises
equipment. With respect to the dedicated circuit and PSTN, the
same analysis applies to Situation 3 as in Situation 2. The
IRS pointed out that, under the contract, Z provides
customer-premises equipment to A to allow A to connect with the
dedicated circuit so that Z can transmit
telecommunications to and from A’s business location.
A controls this
equipment, generally, in the same manner as in Situation 2,
where A owns the
customer equipment; however, in Situation 3, Z owns, and provides
necessary telephone support services for, the
customer-premises equipment and can perform certain remote
maintenance and diagnostic tasks on it.

The IRS noted
that A has a
possessory interest in and operates the customer-premises
equipment. For example, A can relocate or modify
the customer-premises equipment and may attach it to non-Z equipment with Z’s written authorization,
which Z may not
unreasonably withhold. A is liable for any repair
charges or the replacement cost of the equipment if it is
damaged or lost. A
must return the customer-premises equipment or make it
available for removal by Z at the end of the
contract term, or A
will be liable to Z
for the customer-premises equipment’s then-current market
value. A is also
liable for restoration costs beyond ordinary wear and tear.
Since A is ultimately
the party responsible for ensuring that the customer-premises
equipment is available to connect with the dedicated circuit
to allow Z to
transmit telecommunications to and from A’s business location using
Z’s dedicated
circuit and PSTN, the customer-premises equipment should not
be considered part of Z’s broader integrated
network. Therefore, the IRS concluded that Z’s gross receipts derived
from the performance of services are not DPGR. However, Z’s gross receipts derived
from the lease or rental of the customer-premises equipment
qualify as DPGR only if Z meets the other Sec. 199
requirements for the customer-premises equipment.

Implications

Rev. Rul. 2011-24 provides
taxpayers in the telecommunications industry with insight into
the IRS’s interpretation of whether certain gross receipts
constitute DPGR for purposes of Sec. 199. Specifically, the
revenue ruling summarizes the applicable federal income tax
principles that the IRS believes are instrumental in
determining whether agreements are service contracts or
leases.

The three hypothetical situations presented in the
revenue ruling offer taxpayers an additional framework for
determining whether gross receipts are derived from the
provision of services and/or the lease of qualified
production property by indicating which fact patterns the
IRS believes will result in qualifying activity under Sec.
199. Taxpayers that have taken the dedicated-circuit
approach (i.e., the approach under the second two fact
patterns) will not welcome the IRS’s conclusions. Going
forward, taxpayers should carefully review the terms and
conditions of their existing contracts to determine which
factors described in the revenue ruling, if any, are
satisfied. Taxpayers should also be very specific with these
factors when drafting new contracts.

It is important to note that the revenue ruling
recognizes that a single transaction, depending on
applicable federal income tax principles, may consist of
both a services element and a lease element. As such,
taxpayers with facts similar to those discussed in Situation
3 may need to allocate gross receipts between DPGR and
non-DPGR under Regs. Sec. 1.199-3(i)(4).

Furthermore, the revenue ruling may also help taxpayers in
other industries distinguish between services and lease
rentals. However, it should be noted that each inquiry is
fact-specific.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in
Washington, DC.

For additional information about these
items, contact Mr. Dell at (202) 327-8788 or michael.dell@ey.com.

Unless otherwise noted,
contributors are members of or associated with Ernst &
Young LLP.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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